1. Does the company have a high return on Equity
Return on equity is the return on on a particular investment. For example, lets say I invest a $100 dollars for and I receive $10 a year. Then my return on investment is 10%. Sometimes return on equity can be improved through a company borrowing money or in other words through leverage. So lets say I borrow another $100 at 3% interest and invest it at 10% then I am making the difference 10% - 3% = 7% plus the unlevered $10, which totals a 17% return. I have now increased my return through borrowing. This is called financial leverage or operating leverage. There is also capital gains leverage, but we will get to that later. Companies often use financial leverage or operating leverage to boost returns. The downside to this of course, is that leverage can also work against you as much as it can help you. If you place the borrowed money in a bad investment for example. Therefore, just as leverage can magnify gains to the upside, it can also magnify gains to the downside. The return on equity or ROE is then calculated as follows
Net Income / Shareholders Equity
Buffett looks at the return on equity not just for one year but looks at the return on equity over the past 5 to 10 years. This is consistent with Buffett's long term approach to investing, as Buffett wants to buy superior businesses with consistent high returns on equity over the long term. As previously mentioned. leverage or borrowing can increase the returns on equity of a particular business. Hence Buffett tends to shy away from businesses that using a a lot of leverage to boost returns. Buffet tends to view this as artificially inflating returns. Buffett tends to favour businesses that can produce high returns on equity internally or without the use of leverage. Buffet also acknowledges that a highly leveraged businesses can perform badly if the economy or the economics of a business turn against the company. Another point that I want you to keep in the back of your mind is that companies with high returns on equity are usually companies that fit the profile of the other things in a company that Buffett looks for like a large moat or a large amount of goodwill. Hence as you will come to appreciate all of Buffett's strategies fit together, much like a a puzzle.
One can pull up the return on equity of a business easily by using Yahoo finance, entering the symbol of a company, then clicking on Key Statistics and then looking at the return on equity. But, I will demonstrate later the best way to analyse equity is in graph form over a number of years, so you can see what's happening to it over the long te
rm. For example is it improving or decreasing and how does it compare to other stocks in the same industry? Also how does it compare to other stocks in other industries or nations or economies? It is only through comparison that one can gain a true understanding of how good or bad a business is. However the the yahoo number provides a good confirm, to double check the number is right if say you are also using another site and its also a good snapshot indicator to see how the business is doing.
2. How high are the profit margins?
A companies profitability depends on having a good profit margin but also on consistently increasing the profit margin. Once again as with return an equity, a good way to gage this is to look at it in graph form over the last five years. Then you can see if it is increasing or decreasing and also how it compares to other businesses in the same business or different businesses. This margin is calculated by dividing net income by net sales. A high profit margin indicates the company is executing its business well and is controlling expenses, but increasing margins can also be an indication of a good business as opposed to a mediocre business. Buffett has observed that companies with high cost operations typically find ways to sustain or add to their costs. Every dollar spent unwisely deprives the owners of the business with a dollar profit. It is also typically these businesses that have high costs in relative to their sales that also have poor brand recognition and do not have moats around their business. These therefore are the type of business that Buffett avoids.
Therefore as stated earlier in number in (1), we putting together a puzzle. Find a business with strong branding, goodwill, or a monopoly position, and you will often find the other which is high profit margins. One quote that Buffett has said in the past is that if you have a bad business with a good manager and good business with a bad manager, in the long run the reputation of the business usually stays in tact. A good business by definition has high profit margins. Strong branding allows the company to charge higher prices which result in higher profit margins. For an even clearer theoretical example consider the case of a toll bridge. There is strong demand and the bridge is the only way of crossing the river. The toll bridge having fixed costs and a monopoly position would be able charge high prices without fear of any competition. The profit margins would therefore be high. This is the type of business the that Buffett is looking for.
3. How long has the company been public?
Buffett usually considers companies that have been around for at least 10 years. This is because Buffett favours companies whose business models have stood the test of time, but are currently undervalued. As a value investor one must never underestimate the value of historical performance which is an indication of a companies ability or inability to increase shareholder value. The aim of the value investor is to determine how well the company can perform in the future using past performance as a guide. One must always remember however, that past performance is not a guarantee of future performance.
4. Do the companies products rely on a commodity?
Buffett tends shy away (but now always) from companies that rely upon a commodity such as oil or gas. This is because Buffett believes that companies that rely on a commodity have a more difficult task of distinguishing their products or services from their competitors. If the company dos not offer anything different than its competitors in the same business, then Buffett sees little that sets the company apart from its competitors. Any characteristic which is hard to replicate is what a company calls its competitive advantage or economic vote. The bigger the moat the harder it is for a firms rivals to gain a market share.
5. Is the stock selling at 25% discount to its intrinsic value.
To calculate the intrinsic value of a company one must make certain assumptions about company which are (1) How fast will earnings grow over the next 5 to 10 years and beyond and (2) A discount rate, which is the opportunity cost of investing our capital in the company. By opportunity cost can be illustrated with an example, lets say Treasury bonds are yielding 5% then we might require a 10% return on our money to compensate us for investing in a particular stock, because we could get a risk free rate of return of 5% just by investing in Treasuries.
We next take these assumptions and apply them in a series of calculations. We might for example take current earnings of a company from its accounts. And then apply a 10% growth rate to the companies earnings for the next 10 years. To account for for potential earnings beyond the 10th year we could assume a growth rate of 6% per year up until until year 15. We then would take those 2 figures and add them together. The result would be an estimate for the earnings of a company over the next 15 years.
Our next step would be to apply our discount rate and discount those future earnings back to the present value. Again we could illustrate this concept with an example. Lets say I offered you 1 dollar or $1.10 one year from now, which would you take? If you took the dollar today you would be forfeiting the 10 cents that you could have earned on that dollar by waiting 1 year. Therefore the present value today of $1.10 given to us a year from now is a 1 dollar today. The 10 cents is the discount rate for the dollar, which we referred to earlier roughly equal to 10% per year. The discount rate could also be called the opportunity cost of our money. By taking the future earnings we calculated for the company and discounting them to what those earnings would be worth if we to take them today, we would have a present value for those future earnings.
The final steps in the calculation would be to take the present value of the future earnings, subtract the debt of the company and divide by the number of outstanding shares of the company. The result would be the instrinsic value for the company. Buffett would then compare the intrinsic value of the company with the with companies share price. If the companies share price is selling for at least 25% discount to its intrinsic value, Buffett would
see the company as one that has value.
At first glance it might appear that it would be extremely difficult to estimate the future growth in revenues of a company and even to assume a discount rate. But Buffett has certain strategies what he uses to minimize these risks. In addition, I have developed certain strategies of my own which I believe will help minimize the chances making an error in these assumptions and help achieve a more accurate forecast which you can also use if you choose.
The strategies that Buffett uses to achieve a more accurate forecast are several, but some are as follows (1) He conducts several forecasts using different estimates of future earnings growth, to determine several different intrinsic values for a particular company. Once this has been conducted, he then could see if the majority of those different intrinsic values determined are 25% higher then the stock price in question. If this is indeed the case, this would improve the probability that even if Buffett was wrong in the future earnings estimate of a company, it would decrease the probability that Buffett would have made an investment mistake.
Another technique he uses to increase the accuracy of the intrinsic value calculations of a company is related to another Buffett strategy, which is Buffett tends to prefer investing in companies with strong track earnings track records, whereby there is a minimum of 10 years earning history. Buffett believes that companies with strong earnings track records are more likely to have strong growing stable earnings in the future, this is provided of course that these are businesses that he can understand, and usually are simple businesses with tried and tested business models which have been shown to work and preferably have strong branding or goodwill. Take Coke for example, this is a company that Buffett has invested in, in the the past. When Coke fell on hard times in the 1980s, the stock price suffered. Buffett might well have completed an intrinsic value calculation on the stock and determined that it was trading at a discount to intrinsic value. He might have felt even more confident that the stock price was undervalued relative to its intrinsic value, since the company had demonstrated an ability of consistent earnings growth in the past, was a simple business (ie selling soft drinks) whose business model had successful been virtually unchanged for decades.
To summarize, (1) if the business model has been unchanged for decades, then it is unlikely that the business model with have to change or prove unsuccessful in the future. (2) If a business model has been successful for decades, it improves the probability that the business model will be successful in the future.